Making sense of changing market structure

March 2016

Over the past few decades, technology has transformed the way we do many things—conversing through texts, booking flights, checking bank balances…it’s a long list. Neither the stock market nor the bond market have been immune to such dramatic changes, though they may not be as evident or seem as important.

Yet it’s critical for investors and advisors alike to understand the evolution in market structure and dynamics—especially for buying and selling stocks, bonds and ETFs. That way we all can be savvier about how we trade and invest.

Bonds: fewer market makers, less liquidity

Let’s first look at the bond market. Due to increased capital requirements that regulators installed after the 2008 financial crisis, some bond dealers got out of the business of making markets in bonds—meaning they no longer stood ready to buy and sell securities in order to provide liquidity to the markets—and the ones that remained make markets in fewer bonds. Since 2008, for instance, companies have issued more than $1.5 trillion in bonds, yet dealer inventories declined about 80%.1

That has a potentially big impact on investors—and I often point to the housing market to illustrate how. We know it’s best to sell a home when the market is hot. Buyers line up and sellers get close to list price, possibly even more. The wait for an offer usually is short. That scenario is in essence a liquid housing market. Of course, the flip side—selling in a soft or less liquid housing market—isn’t easy. Buyers dry up, it might be hard to find one, and any bids might fall short of the listing price.

In this respect, investments are no different than housing: liquidity is critical and can change the game, costing buyers and sellers plenty. Just like in the housing market, when the bond market becomes less liquid, transaction costs can be higher resulting in potentially lower returns. As such, in a less liquid market, it makes sense to take a longer-term investment perspective.

Equity markets: increased automation

Stock trading has evolved as well. I remember visiting the New York Stock Exchange early in my career. The NYSE was vibrant, loud, and hectic. Specialists wore colored vests and shouted orders. The floor was littered with paper and elbows were flying.

A few months ago I was back at the Big Board, and it was far different. A handful of people milled around. It’s quiet— more museum than exchange. The hum of computers is sometimes louder than the voice of any trader. There’s even a coffee shop on the floor.

Just like many facets of our lives, the markets are becoming more automated...

Just like many facets of our lives, the markets are becoming more automated. When I want to get around San Francisco, I no longer wait to hail a taxi. I use Uber and I’ve learned the best ways to use the app and get what I need out of that service. Similarly, new innovations like automated trading systems, private exchanges or forums known as dark pools, and high frequency trading, which refers to large volume, computerized trading using proprietary algorithms at very high speeds, have changed the way we trade stocks. In addition, if you go back a few decades, there were only a handful of stock exchanges in the U.S.; now there are twelve equity exchanges with dozens of dark pools and they all have slightly different rules. This has added some complexity to the equity market. Just like with Uber, equity and ETF investors would be well served to learn how to operate in a much more automated and technology-driven world.

Investors should be knowledgeable about how to place trades to get the price they expect—because simply placing market orders to buy or sell a stock in today’s automated world may not produce the results one anticipates. Even knowing when to trade is important. For example, investors typically place a significant amount of orders at the market open—when bid-ask spreads are normally the highest. If you wait, even 30 minutes—liquidity often increases and trading is generally easier and cheaper.

What can investors do?

I believe the best thing investors can do is educate themselves about the changing market structure, so they are more informed about trading and investing. There are a lot of resources and educational content available at Schwab and other firms that can help investors adapt to this new environment.

In today’s market, I feel it’s prudent for bond investors to focus on more liquid parts of the market, and to regularly review their portfolio’s liquidity. It also makes sense to have a longer-term investment perspective. For equities and ETFs, investors also can benefit from learning about how
to trade smarter.

Modernization of the markets has many benefits, but it also requires investors to evolve with the marketplace. I encourage investors to learn more about the changes to market structure and the drivers behind them—education around this topic is critically important in helping them achieve better outcomes.


Marie Chandoha
President and CEO, Charles Schwab Investment Management

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